Types of Contracts and Audits Procedures

Basic Contract Types

The government employs several different type of contract vehicles based on the needs of the government and risk assessment. As the government identifies more risk in the contract, they will manage the contracts more closely, including extensive audit requirements. This means the government assesses less risk in a Fixed Price contract as opposed to a Cost Type contract and cost type contracts include significant accounting and auditing requirements.

The old Information for Contractors Chapter Seven identifies nine major contract types and several specific subsidiary types, but basically contracts fall into three major types. The current Information for Contractorsleaves this helpful information out. (DCAA agrees with the three basic types in their description of the Schedule H of the ICE Model):

Type 1: Fixed Price Contracts

From GSA scheduled ballpoint pens to aircraft, the government purchases items or services on a fixed price. Since the government has already determined a ‘fair’ price for the contract, the government assesses little risk on their part.

On rare occasions, the government may decide the contractor overcharged for the product or services and sends an auditor out to prove it by a ‘Defective Pricing Audit’. If the government determines the contractor overcharged, the government may attempt to recover the money. We worked a case once on a $27,000,000 fixed price contract on which the government suspected they were overcharged and initiated one of these audits. We were able to demonstrate the fairness of the price years after the contractor completed the contract and billed the government.

If the government terminates a fixed price contract before completion it effectively turns into a cost type contract for settlement purposes. The government will assume or force the contractor to adopt accepted cost accounting methods to reimburse any money the contractor believes they are owed or as a basis for demanding money from the contractor.

Thus, government contracting becomes one of those rare areas of business where you can execute a contract, perform on it, and still have the other side come back afterwards, scream unfair, and bill you for what they conclude are excessive profits.

To be fair, contractors, in theory, have a similar right to request an equitable price adjustment if they believe circumstances justify it.

Type 2: Cost Type

The most common type of cost contract is Cost Plus Fixed Fee (CPFF). This is where the contractor is paid for their costs plus a determined fee, typically based on a percentage of the costs.

While indirect rates are a critical part of pricing Fixed Price contracts, indirect rates are a functional part of Cost Type contracts. Contractors bill for their direct costs and then at an agreed upon rate for their indirect costs (fringe, G&A, overhead, etc..). These rates are settled up each year by the contractor submitting an Indirect Cost Proposal (ICP) to the government (typically, DCMA and DCAA).

Cost Type contracts are normally the source of news reports about government overruns on contracts. This all is part of the government’s assessment of these contracts as providing the greatest risk to the government and requiring the greatest supervision.

Because of the enormous government resources dedicated to cost type contracts, both Presidents Reagan and Obama stated as a goal of their administrations the severe reduction of these type of contracts. Despite this, cost type contracts continue to dominate government contracts.

Type 3: Time and Materials

Although common, Time and Material (T&M) contracts can be either fixed price (usually stated and billed in hours as opposed to milestones or totals) or a hybrid of fixed price and cost. If a Time and Material contract participates in one of the indirect rates for billing purposes then DCAA will treat it as a cost contract.

Common Audits and Procedures

DCAA Audits break down into three categories: Structure, Operations, and Special Procedures

Structure

DCAA will audit a contractor’s structure to determine their ability to operate as a federal contractor. Such audits include audit of the contractor’s accounting system, financial capacity, and operational systems (labor charging).

Accounting System — DCAA will audit to determine if the contractor can segregate costs (direct/indirect and claimed/unclaimed). DCAA will also look at billing procedures, accounts payable, and payroll.

Financial Capacity – This is normally the only audit where DCAA looks at the contractor’s balance sheet to help determine if the contractor is financially stable enough to complete the government contracts. DCAA has worked to adapt to this change (focus on balance sheet as opposed to costs), but there are some occasional hiccups. We recently experienced a recent finding by DCAA that a contractor lacked the capacity to complete a three year contract due to losses averaging two million a year. We worked with DCAA until they realized that twenty million in cash reserve should be considered before making a final decision.

Recently, DCAA and DCMA began switching responsibility for this function back and forth between the two agencies.

Operation Systems — In addition to the accounting systems such as billing and accounts payable, DCAA will look at a contractor’s labor charging methods as this involves all contractor employees. The basic program DCAA uses for this is fourteen (14) pages of procedures.

Billing

DCAA will audit contractor billings on several levels.

1. DCAA will randomly select invoices on Cost Type contracts and audit the direct costs. Recently DCAA decide not to restrict voucher or invoice audits to cost type contracts. They now include Time and Material (T&M) contracts in their samples and reserve the right to audit any contract invoicing.

2. As part of the accounting system audits, DCAA will place an emphasis on the billing system

3. As part of the annual Incurred Cost Proposal, DCAA may or may not look at billing. In past years, DCAA would request a schedule from the contractor reconciling all contract costs to billing (costs for cost contracts, billing for T&M). Now, DCAA added their own schedule (Schedule I) to their model Incurred Cost Proposal. Unfortunately, there are a few design flaws with this schedule.

Rates

For small contractors, Interim rate agreements are not the result of audits but the result of a procedure DCAA labels as ‘informal’ as in Informal Forward Pricing Rate Recommendations (FPRRs).

Pricing

DCAA will audit proposals for adequate pricing. This includes direct and indirect.

Final Pricing

Contractors with Cost Type contracts are required to submit a proposal to finalized these rates on an annual basis. In addition, DCAA may audit all contract costs across years after the contract is completed or terminated.

Special Procedures

Typically at the request of a buyer, DCAA will undergo special procedures to address a specific buyer concern about the contractor. A common example is an audit to determine if the price a contractor charged on a completed contract was fair.